The eurozone faces problems that are beyond the control of the president of the ECB

“Whatever it takes.”Mario Draghi’s declaration that he would save the euro could well go down as the most effective three-word statement by a Roman since Julius Caesar’s veni, vidi, vici.

TheEuropean Central Bank president’s statement, followed up with a portentous and vaguely threatening – “and believe me it will be enough” – was made in July 2012. Almosttwo years later, Mr Draghi’s intervention is widely regarded as the turning point in the euro crisis. Investors who were running screaming from the eurozone in the summer of 2012 are now rushing back in.

But whatever the thundering herd of investors may think, it is too soon to declare that Mr Draghi has won the war for the euro.The eurozone still faces deep underlying economic and political problemsthat are beyond the control of the president of the ECB and his colleagues.&amp;lt;div class="storyvideonojs"&amp;gt;&amp;lt;div&amp;gt;&amp;lt;p&amp;gt;You need JavaScript active on your browser in order to see this video.&amp;lt;/p&amp;gt;&amp;lt;img alt="No video" src="http://im.ft-static.com/m/img/logo/no_video.gif" /&amp;gt;&amp;lt;/div&amp;gt;&amp;lt;/div&amp;gt;

What Mr Draghi has managed to do is to buy the euro some time.The borrowing costs of Spain, Italy and even Greece have fallen sharply – easing the pressure on their economies and government finances. But the underlying economic situation in many eurozone countries is still grim. And the political consequences of prolonged slumps are only just beginning to emerge.

When I askedone of Europe’s most influential economic policy makersrecently whether the euro crisisreally is over, he replied: “No, it’s just moving from the periphery to the core.” The argument is that while worries about Portugal, Greece, Ireland and Spain have become less acute, concerns about Italy and even France should actually be rising.

The statistics for Italy, in particular, are shocking.Since the onset of the crisis in 2008, Italy has lost 25 per cent of its industrial capacity and the real level of unemployment is now, according to senior Italian officials, about15 per cent.

Italy’s scope for economic stimulus is limited by EU rules and by the fact that the country’s ratio of debt to gross domestic product is now more than 130 per cent. France’s economic statistics are less bleak but unemployment is still in double digits and the national debt is creeping up to the symbolic level of 100 per cent of GDP.

The good news is that both Italy and France have just appointed charismatic new prime ministers, with liberal economic views.But while Matteo Renzi in Italy and Manuel Valls in France are relatively popular, as politicians go, they are also both operating in countries that are notoriously resistant to liberal economic reforms – and against a backdrop of rising support for illiberal, anti-establishment political parties. It is far from clear that a dash of youthful vigour will allow Mr Renzi to bust through systemic barriers that defeated well intentioned predecessors such as Mario Monti. As for Mr Valls, he has already worried economic liberals by promoting ArnaudMontebourg, the most flamboyantly leftwing minister in the French government.

The new Italian and French prime ministers are also under threat from external political forces – in the form of a potential clash with the EU, and a potential shock from events in Ukraine.Both Italy and France are increasingly chafing at the budgetary constraints imposed on them from Brussels, and policed from Berlin. Mr Renzi argues that Italy’s problem is not deficit spending but a lack of economic growth, which is making its debt burden ever more crushing. President François Hollande of France is said to have argued that the EU can have a live France with a deficit of more than 3 per cent of GDP or a dead France that has succeeded in meeting the EU’s budget constraints. However, those arguments are unlikely to be met with much sympathy in Germany.

A further struggle looms over whether Mr Draghi and the ECB can counter the threat of deflation with a European version of quantitative easing.Mr Draghi seems to be edging towards such a policy. But he too faces deep scepticism in Germany, whose finance minister, Wolfgang Schäuble, bluntly insists that Europe does not have a deflation problem. Indeed, one of the paradoxes of Mr Draghi’s situation is that while he is regarded as a hero in financial markets and in much of Europe, he is still treated with deep suspicion by much of the economic establishment in Germany – which happens to be the country in which he lives. Mr Draghi is said to find this situation wearing.

All of these conflicting forcesmean that the political and economic situation of the eurozone remains finely poised and vulnerable to a significant external shock. A worsening of the Ukraine crisis could deliver precisely that shock. If Russian forces move into eastern Ukraine – and, unfortunately, the signs are mounting that this may be imminent – then the EU will be forced to impose tougher economic sanctions on Russia. The Russians can be expected to retaliate by using the most powerful weapon they have at their disposal: energy. Much higher energy prices would have a severe impact on Europe’s fragile economy. And a return to deep recession would almost certainly favour the radical fringes in Europe.Unfortunately, Mr Draghi has no sway over the Russian government – and not that much influence over the domestic politics of France, Italy or Germany.Yet developments in all of these nations could yet reverse the progress in the eurozone that the ECB president did so much to engineer.I do not doubt that Mr Draghi will try to do “whatever it takes”. I just fear that, ultimately, it may not be enough.

CAMBRIDGE – When the US Treasury recently added its voice to the chorus of critics of Germany’s chronic current-account surplus, it underscored the deep disagreement over what, if anything, should be done about it.The critics want Germany to increase its contribution to global demand by importing more and exporting less. The Germans view the maintenance of strong balance sheets as essential to their country’s stabilizing role in Europe.Both sides’ arguments will certainly receive a full airing at the spring meetings of the International Monetary Fund and the World Bank.Unfortunately, the debate has too often been informed more by ideology than facts.The difference between what a country exports and imports can reflect myriad factors, including business cycles, demographics, investment opportunities, and economic diversification. It can also reflect the government’s penchant for running fiscal surpluses; after all, the current-account surplus, by definition, is the excess of public and private savings over investment.During the first half of the 2000’s, US policymakers chose not to worry about sustained current-account deficits, which peaked at above6% of GDP. They argued at first that the deficits merely reflected the world’s attraction to superior US investment opportunities, an odd position given that the US was not growing especially quickly compared to emerging markets.Later, academic researchers identified more plausible reasons why the US might be able to run large deficits without great risk, as long as investors’ desire for diversification, safety, and liquidity sustained global demand for US assets.But policymakers should have recognized that even these better rationales had limits, and that massive sustained current-account deficits are often a blinking red signal of deeper problems – in this case, over-borrowing by households to finance home purchases.In the case of Germany, of course, we are talking about surpluses, not deficits. And even though the surpluses exceed 6% of German national income and would seem to be on the same order of magnitude as pre-crisis US deficits, one must remember that the German economy is less than a quarter the size of the US (at market exchange rates).However, as the Center for European Policy Studies’ Daniel Gros has pointed out, the issue is not simply Germany. Smaller northern European countries, including the Netherlands, Switzerland, Sweden, and Norway have been collectively running surpluses at least as large as Germany’s relative to national income, and, in absolute terms, their combined surpluses are even larger. So the issue obviously merits attention. But what is the cause, and is it related to policy?Certainly, no one can criticize northern Europe for exchange-rate undervaluation. By almost any purchasing-power measure, the euro seems overvalued (and the Swiss franc even more so).Keynesians look at these surpluses and say that the northern European countries should drive them down by running much larger fiscal deficits to boost domestic demand.They have a point, but they grossly overstate the case. Many studies have shown that changes in private savings and investment tend to offset partly the current-account effects of higher fiscal deficits.For example, larger German fiscal deficits would hardly have been a decisive factor in Europe. Research by the IMF and others suggests that the demand spillovers from German fiscal policy to Europe are likely to be modest, particularly in the eurozone’s troubled countries, like Greece and Portugal. Germany trades with the entire world.The European Commission has recently completed its own report on Germany’s surpluses, concluding that it is difficult to pin down the many factors underlying it, which of course is true. For example, Germany’s capital-goods exporters have benefited enormously from growth in China.The Commission nonetheless arguespersuasively that policies to promote public and private investment would tame the surpluses in the short term and strengthen German growth in the long term.One might add that there are still extensive impediments to competition in the service and retail sectors in many northern European countries. Removing them would increase consumption of all goods, including imports.And Germany is right to point out that its strong balance sheet underpins Europe’s fragile stability today. Would European Central Bank President Mario Draghi’s vow in the summer of 2012 to do “whatever it takes” to save the euro have been nearly as effective if investors doubted Germany’s underlying financial strength and resolve?At the same time, it is also true that Germany could have been more forthcoming and more liberal in using its balance sheet to defuse debt-overhang problems in periphery countries like Portugal and Greece, and perhaps even Ireland and Spain.The bottom line is that large sustained external imbalances are something that global policymakers do need to monitor closely, because, as the US housing bust showed, they can be an indicator of problems that need to be investigated more deeply.And critics of the surplus countries are right that there aretwo sides to every balance, and that policies in both surplus and deficit countries should be subject to review. But it is wrong to believe that simplistic answers, such as more fiscal stimulus or more austerity, are a panacea; more often, the underlying problems relate to debt, structural rigidities, low investment, and weak competitiveness.Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. His most recent book, co-authored with Carmen M. Reinhart, is This Time is Different: Eight Centuries of Financial Folly.

Conventional wisdom has it that the long-term global decline in real interest rates owes much to an increase in the demand for safe assets. Certainly it is true that the accumulation of official reserves by excess savers in the developing world has played an important role and with the eurozone breaking into current account surplus there is now a new excess saver on the block.At the same time the increased real return required by equity investors since the dotcom boom and the great financial crisis has reinforced a portfolio shift towards bonds, resulting in further downward pressure on yields. Yet the more striking thing about today’s markets is surely the extraordinary demand for unsafe assets.

In the credit markets junk bond yieldsare close to record lows. Securitisation is back in fashion in a big way. There is a slide afoot in lending standards, with a reversion to such pre-2007 bad habits as payment-in-kind notes and “cov-lite” loans that provide poor protection for investors.

Mexico, admittedly with a good domestic economic story to tell, managed to sell a 100-year sterling bond last month on a coupon of 5.75 per cent. At the same time the yield on Spanish and Irish sovereign five-year bonds last week fellbelow comparable US Treasury paper.

Central bank intervention

That is quite a tribute to the power of the central banks, which have rigged the market in spectacular fashion. Mario Draghi at the European Central Bank has even done it on the cheap, putting up no money via the ECB’s outright monetary transactions programme to support his assertion that the ECB would do “whatever it takes” to save the euro. At the same time he has promoted a carry trade whereby banks have borrowed cheaply from the ECB to buy eurozone sovereign debt – hence the fancy ratings for Spain and Ireland, among others.

In the US, the UK and Japan, meantime, the resort to quantitative easing has succeeded in stirring investors’ appetite for risk, even if its impact in the real economy has latterly failed to impress. Equity market valuations, too, reflect this prestidigitation.

As Richard Fisher, president of the Reserve Bank of Dallas, pointed out last week, the price/earnings ratio of stocks was among the highest decile of reported values since 1881, while the economist Robert Shiller’s inflation-adjusted PE ratio had reached 26 as the Standard & Poor’s 500 hit yet another recordhigh. That compares with a ratio of 30 before Black Tuesday in 1929 and an all-time high of 44 before the dotcom implosion at the end of 1999. Since bottoming outfive yearsago, the market capitalisation of the US stock market as a percentage of the country’s economic output has more thandoubled to 145 per cent – the highest reading since the record was set in March 2000. It is hard not to believe that valuations are running ahead of earnings prospects.Corporate manipulationAnother indication of fierce risk appetite is the rise in margin debt. This has been setting historic highs for several consecutive months and, according to the latest data from the New York Stock Exchange, now stands at $466bn. That is double the level at the start of 2010.The central bankers are not the only ones to have successfully rigged the markets.Executives in the quoted corporate sector in the English-speaking world have been borrowing furiously at low rates of interest to buy back equity. As well as pushing up share prices the resulting reduction in the number of outstanding shares causes earnings per share to increase even when there is no increase in revenue or improvement in profit margins. This, of course, leads to a boost to bonuses and other equity-related incentives based on performance yardsticks such as earnings per share and return on equity that bear no strict relation to value creation. Does this mean, contrary to Margaret Thatcher’s famous assertion, that you can buck the market? Well, yes and no. There is an issue of timing. In effect, central bankers have been repeating the trick used repeatedly by former Fed chairman Alan Greenspan of asymmetric activism. When markets bubbled, Mr Greenspan’s Fed failed to curb the euphoria, but when they collapsed the central bank came to the rescue. Under his successors we are witnessing more of the same but on a colossal, experimental scale. The coexistence of strong demand for both safe and unsafe assets is not a coincidence. As in the period before 2008 low nominal and real interest rates have driven investors into a search for yield. That is now, once again, associated with a decline in bank lending standards, as people are lulled into complacency by low default rates. It brings to mind the adage: if it’s too good to last, it will stop.Copyright The Financial Times Limited 2014

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